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The Renminbi Is a Red Herring

Treasury Secretary John Snow has urged China to adopt “a flexible, market-based exchange rate” for the Renminbi, which is currently fixed at 8.28 to the dollar. Flexible exchange rates can provide benefits to the countries that use them. In recommending that China float its currency, however, the Bush administration is wrapping a protectionist policy in free-market rhetoric. The administration’s real goal is to make Chinese exports less competitive against U.S. manufacturers-and that’s bad policy for everyone, especially consumers.

President Bush’s political advisers want to solidify support with American business. Additionally, they want to prevent Congress from passing legislation, such as that co-sponsored in the Senate by Republican Lindsay Graham and Democrat Charles Schumer, which would impose a 27.5 percent across-the-board tariff on Chinese goods if the Renminbi were not floated.

The administration wants the dollar to fall against the Chinese currency. Its policy is one of monetary protectionism, in that it tries to achieve a trade objective by using monetary policy to change a nominal exchange rate. Just as with ordinary protectionism, the goal of monetary protectionism is to restrict imports and stimulate exports.In our Cato Institute study, “China: Just Say No to Monetary Protectionism,” we detail the pitfalls of that policy.

The Renminbi is a red herring. Many currencies are pegged to the U.S. dollar, including the Hong Kong dollar. Why haven’t U.S. officials hectored the Hong Kong government on it currency system? The answer is that, in contrast to Mainland China, Hong Kong allows the free movement of both goods and capital into and out of the Special Administrative Region. Hong Kong is also exemplary in its adherence to WTO rules.

Certainly, one can question whether China is meeting all its obligations under the WTO. The United States may have legitimate trade grievances against China. The solution is to pursue such grievances according to WTO rules. Rather than lead by example, however, the Bush administration has pursued protectionism in the name of advancing free trade. Illegal steel tariffs, agricultural subsidies, and the recent action on Chinese apparel exports are just three examples.

China’s controls on the movement of capital out of China (“capital controls”) are the source of whatever problem may exist with its nominal exchange rate. Getting rid of those controls would compel China’s monetary authority to deal with pressure to revalue its currency. Either a new peg or a free float would follow.

If Chinese leaders were to abandon capital controls, U.S. protectionists would lose an argument against China. At the same time, China’s central bank would no longer need to subsidize America’s budget deficits and capital formation through its purchases of U.S. Treasury obligations. Economist David Hale estimates that the monetary authorities of China and Hong Kong have purchased nearly $100 billion of U.S. Treasury securities (including mortgage-backed securities) in the past 18 months.

At this time, China is in no position to eliminate capital controls. Such a policy move would compel the government to confront the problem of non-performing loans at its four large, state-owned banks. Cleaning up these loans, estimated at $300 billion-400 billion, will take years. Perhaps the government is taking the first steps with its announced $45 billion bailout of the Bank of China and the China Construction Bank. A full resolution in the banking sector would force a dowsizing of state-owned enterprises (SOEs), such as the source of the nonperforming loans. With two-thirds of the labor force still employed by SOEs, a sudden end to capital controls would result in social upheaval and political instability.

The Bush administration does not want an unstable China, and so will not press on the real economic issue. Calling for China to float its currency is political rhetoric to salve U.S. domestic political wounds, not serious international economic policy.

Hong Kong’s monetary experience confirms that a monetary authority can maintain a peg if it forgoes monetary sovereignty. Under Hong Kong’s Currency Board, changes in the domestic currency supply are triggered by changes in international reserves. Price stability cannot be guaranteed under such a system, and five years of deflation in the city state are attributable in part to its monetary system.

It is doubtful whether China would opt for such a system once it opens both its goods sector and capital markets. Perhaps after one or more devaluations, China will float its currency.

The citizens of both China and the United States will benefit when China moves closer to a market economy. In the meantime, the leaders of both countries need to avoid protectionism in all forms, including monetary.

Gerald P. O’Driscoll, Jr., formerly a vice president at the Federal Reserve Bank of Dallas, is a senior fellow at the Cato Institute. Lee Hoskins, formerly president of the Federal Reserve Bank of Cleveland, is a senior fellow at Pacific Research Institute.